New Research Department study: A Structural Investigation of Israeli Labor Market Dynamics

  • The study presents a detailed macroeconomic model of the Israeli labor market.  Two analyses are presented based on this model, the first retrospective, and the second prospective.  The first is an empirical analysis of macroeconomic developments in the Israeli labor market in the years preceding the COVID-19 crisis.  The second presents a theoretical discussion of the desired policy in view of the structural changes that will likely take place in the labor market due to the crisis.
  • The unemployment rate in Israel declined from about 10 percent in 2009 (a high rate that was due to the Global Financial Crisis) to about 3.5 percent in 2019 (before rising as a result of the COVID-19 crisis). According to the study, the main contribution to this significant decline is the gap between the growth rate of labor productivity and that of real wages during those years—a gap which made it more worthwhile to employ labor, thereby contributing to the decline in unemployment.
  • Looking forward, and considering structural changes that are likely to take place in the labor market due to the COVID-19 crisis, labor market policy has to take into account the development of the ratio between job vacancies and unemployment (“labor market tightness”), and not just the development of the number of unemployed.

 

 

A new study published today by Dr. Alon Binyamini of the Bank of Israel Research Department presents an empirical macroeconomic model that combines discussion of a variety of labor market variables and characteristics.  In addition to presenting the model, the study includes two model-based applications.  First, retrospectively, the model helps to analyze developments in the economy during the years that preceded the COVID-19 crisis.  Second, prospectively, the study presents an analysis of policy alternatives for the future, in view of structural changes that are likely to take place in the labor market as a result of this crisis.

 

During the decade that preceded the COVID-19 crisis, the unemployment rate in Israel declined from about 10 percent in 2019 (a high rate that was due to the Global Financial Crisis) to about 3.5 percent in 2019 (before rising as a result of the COVID-19 crisis).  In a macroeconomic view (that ignores the industry composition of the economy and its development during the decade), the study attributes this significant decline in the unemployment rate mainly to the slow pace of increase of real wages (slow relative to the increase in labor productivity).  Such a development makes it more worthwhile to employ labor, thereby leading to an increase in the employment rate and a decline in the unemployment rate.






Looking forward, the COVID-19 crisis led to the adoption of new approaches and changes in the labor market.  Insofar as these changes are adopted following the abatement of the crisis as well, they become structural changes in the labor market that are likely to be accompanied by a temporary impairment of the matching between employers’ needs and requirements and employees’ capabilities and preferences. Such a development should be reflected in unemployment that declines only gradually despite the high level of job vacancies.  Essentially, as the figure shows, such a development is exactly what has been happening in the Israeli economy in recent months—the number of job vacancies is about 30 percent higher than what it generally was in the years preceding the COVID-19 crisis, while the number of unemployed is about 50 percent higher than it was during those years (and would be even higher had it included those unemployed according to the broad definition in use since the outbreak of the COVID-19 crisis).  It is therefore important to meticulously designing the criteria for entitlement to unemployment benefits to balance social and economic considerations with the need to incentivize employment (and “exit” the state of unemployment) in a changing labor market.

 

In view of this, and to illustrate the use of the model as a tool for analyzing various policy alternatives and their macroeconomic effects, the paper presents a theoretical discussion of the policy alternatives for exiting an unemployment-increasing crisis. According to the model, in most cases, job vacancies and the unemployment rate are expected to develop in opposite directions, along what is known as the Beveridge curve.  When that is, in fact, the case, welfare policy that takes the unemployment rate into account could be optimal even if it does not take into account the development of job vacancies in the economy.  The exception is a situation in which there is some impairment to the matching between employers’ demands and employees’ capabilities and preferences.  Such a change would, according to the model, lead to the development of unemployment and job vacancies in the same direction (meaning a movement of the Beveridge curve, and not movement along it).  In view of this type of change, the economy would show a simultaneous increase in both job vacancies and the unemployment rate.  In such a situation, which we may see in the near future due to possible structural changes in the labor market, welfare policy must take into account not only the development of unemployment, but also the development of job vacancies (meaning the opportunities available to the unemployed).  Otherwise, policy may de-incentivize employment in a way that would entrench the combination of high unemployment and firms that are finding it difficult to fill job vacancies.  The model presents a comparison between a welfare policy that takes into account only the unemployment rate, and a policy that also takes into account the number of job vacancies in the economy.  The comparison contributes to illustrating the message that, with the aim of reducing the disincentive to work, welfare policy must relate to the development of the ratio between the number of job vacancies and the number of unemployed (“labor market tightness”), and not just the number of unemployed.  The comparison also enables a discussion of the interrelationships between fiscal policy, which, among other things, is entrusted with determining the scope of and criteria for unemployment benefits, and monetary policy, which determines the level of the interest rate in the economy.

 

The model presented in the study combines theoretical and empirical views.  It is based on a modern macroeconomic theory for labor market analysis, and it is calibrated and estimated using the Bayesian method.  As such, the model enables an analysis that is, at the same time, both qualitative and quantitative.  The analysis also helps to identify developments in the economy, discuss macroeconomic risks, various policy alternatives, and the interrelationships between them and monetary policy.